Treasurys get buried

With yields dropping to record lows, real estate investment pulls ahead

Jan.January 03, 2012 03:47 PM

Historically, institutional investors looking to park their cash in real estate have compared brick-and-mortar investments to Treasury notes before getting out their checkbooks.

The thinking went that investors concerned principally with safety would choose Treasurys, while those more interested in high returns would go with real estate.But now, with Treasury yields near record lows, many are fleeing that traditionally safer investment and opting for real estate, where they can get relatively higher returns.

According to the research firm Real Capital Analytics, the spread between national cap rates, which measure the rate of return on a real estate investment, and 10-year Treasury note yields hit a decade-long high in September.

Ten-year Treasurys, which only five years ago yielded 4.56 percent, have now dropped to below a miniscule 2 percent.

RCA’s most recent data shows that in September, the 10-year Treasury yielded 1.98 percent, while the cap rate for core properties nationwide averaged 7.1 percent.

The cap rate for New York City office properties, meanwhile, was 5.42 percent.

The drop in Treasury yields to miniscule levels has made real estate more appealing as an investment during the last 18 months, which has, of course, been a rocky economic time.

“The attractive spread of Treasurys is one of the reasons why commercial real estate is a favorite asset class among investors now, despite headwinds in the economy,” said Dan Fasulo, managing director of Real Capital.

Indeed, the drop in Treasurys, which have been on the decline for 10 to 15 years, intensified in 2011 to the point that it isn’t even useful to compare them to real estate anymore, said Kenneth Patton, professor at NYU’s Schack Institute of Real Estate.

“The time-honored relationship is gone,” he said. “People now use corporate debt swaps for a benchmark. You’d get thrown out of an office for saying ‘spread over Treasurys.’”

That new calculus boils down to an issue of investment return.

When inflation — which totaled 3.9 percent nationally during the 12 months through September — is factored in, Treasurys are actually offering negative real yields.

For pension funds and insurance companies, which rely on current investment income to make payments to beneficiaries and claimants, the choice between losing ground to inflation with Treasurys and garnering higher yields in real estate has now become a no-brainer, experts say.

As opposed to Treasurys, where investors are basically losing money, real estate is currently getting them a 6 percent yield and inflation-protected leases, Fasulo said.

“All of a sudden commercial real estate looks awfully rosy [to investors],” he said. “I would argue that commercial real estate has been one of the main beneficiaries of the Federal Reserve’s low-interest-rate policy. Without that, a lot of major [real estate] players would be in bad shape.”

Patton agreed: “Investing in Treasurys really isn’t investing,” he said. “It’s like insurance.”

For the lenders on the other side of the equation, real estate also represents a superior investment to Treasurys, thanks to the yield differential, Fasulo said.

“Lenders need to decide where to put their depositors’ money,” he said. “When Treasury rates are so low, it encourages banks to lend for higher rates of return [rather than buy Treasurys]. They certainly like lending to commercial real estate, especially in the best markets, like New York.”

“It’s almost as if New York City has become the T-bill of real estate, Manhattan in particular,” added Peter Hauspurg, CEO of real estate investment advisory firm Eastern Consolidated.

Those investors who opt for real estate over Treasurys do still have to decide in which geographical areas to put their money. And that choice depends on how much risk they’re willing to take.

“When you go outside of primary markets — New York, Washington, etc. — it’s still pretty downtrodden. And people make money buying at the bottom,” said Jahn Brodwin, senior managing director for FTI Schonbraun McCann Group.

Of course, the investment risk is higher in non-gateway cities.

Washington, Boston and San Francisco have cap rates 100 to 200 basis points higher than those in New York, Brodwin said. But in return for accepting the lower yields available in New York City, investors expose themselves to less risk.

“People view New York City as very safe,” Brodwin said.

That’s a point that came into clear view in the aftermath of the financial crisis. “Even at the depth of the downturn there was a market in Manhattan. That can’t be said for many markets around the country, which basically froze up,” Fasulo said.

Hauspurg said the paltry yields available from Treasurys have made his clients happy to accept cap rates under 4, 5 and 6 percent.

Cap rates for New York City office properties have dropped from 9.36 percent in January 2001, according to RCA data. They fell throughout the boom, dropping to a low of 4.34 percent in February 2008. And, they actually dipped below 10-year Treasury yields in June and July of 2007. Today, of course, that’s no longer the case.

“A buyer of one deal we worked on said, ‘Why should I have a 1.5 percent Treasury bond?’” instead of real estate, Hauspurg said. “People have said that to us in many ways.”

Given the Fed’s commitment to keep short-term interest rates low until mid-2013, investors will likely continue to accept lower cap rates on New York City properties as an alternative to Treasurys, experts say.

“Cap rates could keep going [down]. I wouldn’t be surprised to see sub-3 percent,” Hauspurg said.

Indeed, he’s currently working on a sale of a luxury apartment complex in Manhattan that could end up with a cap rate below that level.

Even if investors have to accept a low cap rate now, they can look forward to higher yields on their properties in the future, as economic recovery drives rents higher, said David Eyzenberg, head of commercial real estate at NewOak Capital, a Manhattan-based investment advisory firm.

“Looking at real estate fundamentals, we haven’t had a bounce back because we haven’t had job growth, etc.,” he said.

However, Eyzenberg added, that should change.

Fasulo said the rally in Manhattan commercial real estate should last at least a few more quarters.

“You don’t get much visibility beyond that, because there is so much uncertainty around the country and world,” he said.

Indeed, what will likely put an end to the slide in cap rates is when Europe’s debt crisis spreads here, pushing interest rates, including Treasury yields, higher, Hauspurg said.

“It’s only a matter of time until we run into our own problems. Interest rates will rise at some point, and then all bets are off,” he said.


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